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THE DAY AHEAD: AOL, the value stock

America Online (NYSE: AOL) reports a strong fiscal first quarter, delivers strong advertising and commerce sales and what does it get from Wall Street's peanut gallery? A lot of nit-picking over the company's advertising backlog, which was flat at about $3 billion.

Analysts were chock full of worries about AOL Thursday and shares slipped despite some strong financial results. After the bell Wednesday, AOL reported net income of $350 million, or 14 cents per share, not including special charges. Sales were $2 billion and officials were bullish as usual.

It was your typical AOL quarter, but instead of the typical Wall Street cheerleading you got a lot of negative comments Thursday. It's cool to be bearish. "For the first time in years, we can't raise estimates," lamented Merrill Lynch analyst Henry Blodget in a research note. Awwww.

Lehman Brothers analyst Holly Becker, who made her name flagging Yahoo! (Nasdaq: YHOO), also said AOL was hurt by the online ad slowdown.

These AOL sourpusses said the company's ad/commerce backlog, which was flat at $3 billion, and deferred revenue, which fell, proved AOL was hurt by the dot-com implosion.

But that bearish case doesn't hold up. For a reality check, I called William Blair analyst Abhishek Gami, who calls it straight and isn't tangled up with the sheep crowd. Gami was surprised by the negativity from some analysts, who were obviously playing along with the market sentiment. "I'd almost call AOL a value play," said Gami, who rates AOL a "strong buy."

Gami said the concerns about ad backlog and deferred revenue were overblown. CS First Boston analyst Jamie Kiggen and SG Cowen's Scott Reamer agreed.

Here's why AOL's alleged trouble spots may actually be positives.

  • Backlog: Ad/commerce backlog was flat at $3 billion. The common view is AOL is being zapped by the online advertising slowdown. Gami sees things differently. For starters, AOL's backlog is down because the company cut the average length of its contracts, said Gami. If you shorten the contract length, backlog falls. In addition, Gami reckons that AOL held back deals ahead of its merger with Time Warner. Why land huge deals with regulators sniffing around?

    To Gami, the fact AOL shortened its contracts and maintained backlog levels indicates a lot. AOL's first quarter backlog was 10 quarters, down from 11 quarters the prior quarter. That means there are shorter contracts, but bigger dollar values.

  • Shorter contracts: AOL cut contracts because it plans to boost prices later. Once the Time Warner deal is finished, AOL will probably repackage many deals to take advantage of the multimedia synergy. AOL is just starting to take advantage of Time Warner's relationships. When the deal closes, there'll be a slew of deals. "The value of this real estate isn't going to go down," said Gami.

  • Deferred revenue: Yes, deferred revenue fell sequentially, but all that means is AOL isn't a collection agency. Behind a lot of dot-com profit warnings is this fact -- companies can't get new business because they're too busy trying to get paid by the young and fundless. AOL has established customers and doesn't have to get all the cash up front. Proctor & Gamble is going to pay its bills.

    AOL has half the advertisers of Yahoo, but a lot more revenue. For Yahoo, which has 40 percent of its revenue riding on dot-coms, deferred revenue was an issue because the portal was trading at a significant premium, argued Gami.

    "AOL is almost trading below its growth rate," said Gami. AOL is trading at 18 times to 19 times 2001 earnings before interest, taxes and depreciation, he said. AOL Time Warner will easily post annual growth of 25 percent a year.

    The big question is what will make AOL a growth stock again. The answer may surprise you. Most folks think that once AOL becomes AOL Time Warner, Wall Street will fall in love again. Don't count on an immediate boost.

    Instead, look for two developments to push AOL shares. For starters, the dot-com collapse could actually help. Online advertisers that were burned by defunct dot-coms aren't going to toy around with the small fry again. Advertisers will go big and that means AOL. The big is beautiful theory works on many sides of AOL's business. As small Internet service providers croak, it's quite possible subscribers will go to a stable entity such as AOL.

    AOL Time Warner's customer wins will also be pivotal. There'll be a slew of big sponsorship deals announced across AOL Time Warner properties. There'll also be new revenue streams such as AOL-TV and other products. Add it all up and analysts will be cheerleading again in no time.

    "My target is $90 for the year, and I'm confident about where AOL is right now," said Gami. "If this is how AOL performs in a bad market that'll last for one or two quarters, imagine how it'll do in good times." TDAIN
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